Our first Talk To Me Like I'm Stupid thread turned out really well. There are some great answers in there. To highlight a few really knowledgeable one's, I thought Sf45, Cynic, and Pacal-Emmanuel Gobry offered some really helpful answers. But my favorite came from Darius Tahir. I thought the following should be the first thing out of anyone's mouth whenever someone says, "What the hell is a derivative?"
A while back me and my buddies were playing poker. I got to the game late so there wasn't a spot for me (the game was capped at eight people). So one of the players was playing absolutely awful and losing a ton of cash. I turn to another guy who wasn't playing and said, I bet he'll be the first out. So we made a bet on it (mostly for sport).
So, if poker were finance, here's how it would be: the poker players are investing straightforwardly in stocks and bonds and what have you. They're investing in an asset directly. I'm investing in a derivative: my bet is derived from the standing of someone else.
Darius, you can shoot me an e-mail and we'll get you on for that guest post.
I'd like to follow up just to make sure I'm getting the housing portion of this conversation. Credit default swaps allowed lenders to defray the risk for home loan defaulting. These swaps were then bundled and sold. The value was based (1.) on the quality of loans (2.) And the fact that it was highly unlikely that the entire bundle would default, much less a critical mass of bundles. But the ability to bundle the swaps made it easier to loan, thus changing the profile of the borrowers. This meant the data was useless, and a crash (though no one knew when) was almost certain.
Do I have that right?
We'll have another question for Tuesday.
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and We Were Eight Years in Power